Brace for a Gentle Decline: Slow Deflation vs. a 40% Market Drop

Current forecasts suggest that the likelihood of a U.S. stock market crash is below average. According to State Street Associates’ “froth forecasts,” which draw on Harvard professor Robin Greenwood’s research, there’s an 18% chance of a 40% market decline within the next two years, compared to a five-year average of 26%.

This outlook extends to the high-tech sector, known for its recent dynamic returns. State Street estimates its crash probability to be four percentage points lower than the five-year average.

Yale University’s Will Goetzmann contends that bubble predictions often reflect more about the analysts making them than the actual risk. Many lack precise definitions and criteria for what constitutes a bubble or a crash, leading to more subjective and less reliable predictions.

The crash probabilities by Greenwood and State Street are linked to the market’s performance over the past two years. Higher past performance correlates with a higher likelihood of a crash. For instance, a 100% price increase over two years raises the crash probability to 50%, while a 150% increase nearly guarantees it.

However, the S&P 500’s 48.9% return over the past two years is well below these critical levels.

Some argue that the market’s reliance on the largest stocks indicates an imminent bubble. The cap-weighted S&P 500 has outperformed the equal-weight version by more than 10 percentage points this year and by 12 percentage points last year.

This concentration in large stocks is viewed by some as a sign of market vulnerability. However, historical data since 1970 shows no consistent pattern supporting this theory.

Although the U.S. stock market is overvalued, there are various ways it can correct itself besides crashing. According to State Street’s forecasts, a gradual adjustment through mediocre performance is more likely than a sudden crash.